Interest-Only Loans Explained

When lenders take on more risk, they expect to get a greater return, and interest-only loans are no exception.

An interest-only mortgage is a home loan where the borrower makes monthly payments on only the interest they owe their lender for the first few years of their loan. During this period, which usually lasts up to 10 years, the borrower will not put any money toward the principal of their loan unless they intend to. As a result, interest-only loans can be significantly lower on a month-to-month basis than mortgages that include principal, but the loan balance will remain unchanged during this time.

Who Benefits from Interest-Only Loans?

Interest-only loans are for borrowers who need a lower monthly payment at the start of the home loan but are prepared for the negative consequences. Let's say you're a young family with uncertain job prospects but you're looking to enter the real estate market right away. By taking an interest-only option on your mortgage, you can keep your payments as low as possible until you have the income required for a full amortization payment. This also helps families who have unpredictable income streams. In fact, making an extra payment on an IO loan will make the next month's payment cheaper.

Families who want to move into more house than they can immediately afford can also benefit from interest-only loans. By making the lower monthly payments on interest alone at the start and paying more later when your income improves, you can have the home you want without the hassle of switching homes at some unknown point in the future. Smart investors may also want the cash used for principal on their loans for other investments that can beat the rates on their mortgage.

The Hazards of Interest-Only Loans

The primary hazard of interest-only loans is believing you can benefit from one when you, in fact, can't. This happens because there are quite a few misconceptions common with people looking at IO loans. Many borrowers falsely believe that:

Interest-only loans have lower interest rates. IO loans often have lower rates than traditional fixed rate products, but this is because they are ARMs, not interest-only loans. In fact, lenders consider IO loans a greater risk due to how much longer it takes for the principal to be paid.

You can avoid paying mortgage insurance with an interest-only loan. If you put less than 20% down on an IO loan and don't see a line item for mortgage insurance, the lender is paying for it and including it with other costs passed onto you. Lenders will not risk going without insurance on interest-only products.

Interest rate is fixed during the entire period of interest-only payments. This may or may not be true. Because IO loans have adjustable rates, your initial interest rate can be as long as 10 years or as short as 1 month, but it has nothing to do with the length where you can pay interest only.

It costs less to amortize an interest-only loan. It's unknown why this idea has become so common, but there is no truth to it. Making full amortization payments on an interest-only loan will cost just as much as paying off a loan without one.

If you've thought about getting an interest-only loan for any of these reasons, you need to seriously reconsider your options before signing any contracts.

How Much More Does an Interest-Only Loan Cost?

When lenders take on more risk, they expect to get a greater return, and interest-only loans are no exception. If you have two loans that are identical, other than one having an interest-only option, the IO home loan will be priced higher. The difference in interest rate between the two can range from .3% to a full percentage point. You'll need to decide if paying tens of thousands more in overall interest is worth the temporary savings at the beginning of your home loan. In addition to increased rate, you'll need to account for adjustments in your ARM when the time comes.

Before you can decide if an ARM with an interest-only option is the right financing for you, you'll need as much information as possible about the loan. Your loan officer can provide most of the data you need, and you can plug this data into a variety of online calculators that will help you predict exactly how much you'll owe over the course of your home loan.